616 Making Key Strategic Decisions
interest rate is less than 9%. Victoria determines that ACME is in the 40% in-
come tax bracket. Therefore, ACME’s after-tax cost of debt is 5.4% as pre-
sented in Exhibit 18.9.
Weighted Average Cost of Capital
Victoria estimates the optimal capital structure for ACME as 40% debt and
60% equity based on her analysis of the average capital structures of publicly
traded companies and then considering that ACME does not have the same ac-
cess to capital sources as public companies.
Based on this weighting between debt and equity, ACME’s weighted av-
erage cost of capital is 13.3%. The calculation is presented in Exhibit 18.10.
Discounted Cash-Flow Calculation
As previously discussed, ACME’s forecasted invested capital net cash f lows for
2001 to 2005 are discounted to present value as of the December 31, 2000, val-
uation date. The discount rate is ACME’s weighted average cost of capital—
13.3%. In addition, the residual value of ACME in 2005 is discounted to
present value using the same rate.
Victoria prepares Exhibit 18.11 that presents the resulting value from dis-
counting the cash f lows for the five-year period and also discounting the resid-
ual value. It assumes that the annual cash f lows are earned equally throughout
each year. Therefore, the present value calculation for the annual cash f lows
uses the middle of each year (June 30) to determine the length of time for the
present value calculation. This is called the mid-year convention. For example,
EXHIBIT 18.9 ACME Manufacturing Inc.:
Cost of debt.
ACME’s borrowing rate 9.0%
Multiply by the tax effect (1 −Tax rate of 40%) 60%
ACME’s cost of debt 5.4%EXHIBIT 18.10 ACME Manufacturing Inc.:
Weighted average cost of capital.
Cost of equity (above) 18.6%
Equity weighting 60%
11.1%
Cost of debt (above) 5.4%
Debt weighting 40%
2.2%
ACME's weighted average cost of capital 13.3%